The Inability to Make Hard Choices

Across the op-ed pages of most newspapers, throughout the blogosphere, and on most political talk shows, there has been a harsh criticism of the deficit-reducing actions that world governments are pursuing. All of these critiques have based themselves on the largely repudiated Keynesian macroeconomic model, the model under which the very real crisis of stagflation of the 1970s could not occur.

 

Basically, the argument goes something like this: because global economies are still weak, unemployment remains high, and many people who had not needed public services in the past do now (food stamp participation has spiked), cutting spending is the worst thing that could be done. The problem with cutting spending is that it constitutes a significant part of the national economy, so if government jobs are cut, for example, those people can no longer consume to stimulate the economy. The New York Times’s May 29^th editorial sums it up: “[A plan of cuts] has a fundamental shortcoming: it relies on deep budget cuts from countries that are in a recession or teetering on the edge. Several have weak governments that may not be able to carry through the prescribed fixes. Even if they do, the budget cuts are likely to make them even weaker.” So, this line of argument would have countries stay in the red until the economy strengthens.

 

Yet this argument misses the most obvious point to any shareholder or investor: someone needs to buy the debt and be compensated appropriately for assuming the risk. The reason why Greece became a crisis is because it tried to follow that model, but investors would not buy the debt. To say that countries should forge boldly ahead with borrowing and spending assumes that somebody will lend them the money, which has been shown recently as a potentially spurious notion.

 

Martin Wolf of the Financial Times asserts that “giving the markets what we think they may want in future — even though they show little sign of insisting on it now — should be the ruling idea in policy,” and for that reason, deficits should be cut now. It is true that US debt investors have not yet called for increased interest rates, but the reason to cut now is to prevent them from having to demand. Given the time that it will take to enact meaningful economic policy reform, policymakers should take the opportunity to listen to the vocal objections of investors before investors have to object in terms of what debt they do and do not buy.

 

Moreover, the US does not suffer from a problem of under-taxation, but instead from over-spending. Tax revenues as a percent of GDP are set to rise from 14.9 percent in 2010 to 20.2 percent in 2020.  This would be pretty close to a post-War record, and this increase is far ahead of the post-1970 average (18.1 percent of GDP).  So, at this point, tax revenues are beating out the historic benchmarks to an almost record-breaking degree. Whereas tax revenues have increased, spending is only slated to fall from 24.1 percent in 2010 to 23.3 percent in 2020. 

 

Now, this is all based on current and historic Congressional Budget Office data and analysis, but the office must act within certain parameters, the most significant being that it cannot assume that politicians will modify the funding streams or taxes in the future, which is generally a ludicrous assumption to make.  But, accepting this ungrounded analysis, even if spending went down to the optimistically predicted level of 23.3 percent of GDP, this spending level would still be above the post-1970 average of 20.7 percent of GDP.

 

The fact that taxes have increased substantially but that spending has increased much faster shows the deficit problem to come uncontrovertibly from over-spending.  Spending has been much lower as a percentage in the past: since, 1970, spending has been below 19 percent of GDP seven times, mostly in the 1990s and early 2000s with a low point of 18.2 percent of GDP when Clinton left office. If spending were to come back down to historical levels, the US could easily have a balanced budget and not be beholden to foreign investors.

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